This is the first post of a multi-part series on Transforming China’s Grid, where I will be critically examining China’s efforts to reinvent and decarbonize its power sector and related energy goals. I begin with China’s efforts to create provincial and city-level carbon trading pilots as well as major obstacles to establishing a national system that can link with other ETS markets. Future installments will look at the technical and regulatory barriers to high wind integration, the future of renewable energy incentive policies, and the challenges in moving away from coal.

China’s first mandatory carbon emissions trading system (ETS) pilot debuted last month before a packed auditorium in the southern city of Shenzhen. China’s first official carbon trade was greeted with fanfare and a well-choreographed script of climate officials. Shenzhen is the first of seven cities and provinces expected to unveil cap-and-trade programs in China this year, which drew skeptical reactions from foreign onlookers based on the first day’s low volume – 21,120 tons at 28-30 yuan / ton ($4.55-$5.05).

The ETS pilots are a small market-based component of a broader climate policy that has historically relied on administrative measures carried in five-year plans. The overriding priorities for provincial officials are energy and carbon intensity reduction targets, most recently allocated in 2011. Nationally, these amount to 16% and 17% reductions in energy use and carbon emissions per unit GDP, respectively, by 2015; a 40-45% carbon intensity reduction below 2005 levels by 2020. However, ensuring an early emissions peak (i.e., before 2030) will require more flexible approaches, in particular, market mechanisms, for which the ETS pilots are a useful bellwether. While the merits of the pilots should not be judged by the first trading day, significant obstacles stand in the way of creating a national ETS by 2016, as currently envisioned by the Chinese leadership. Even before the remaining six trading pilots ring the opening bell, we have a good sense of what these obstacles will be.

[Editor’s note: we’re excited to mark the launch of our second exclusive column at TheEnergyCollective.com: “East Winds, with Michael Davidson.” Michael is an MS candidate and predoctoral student in engineering systems at the Massachusetts Institute of Technology. He is currently reporting from Tsinghua University in Beijing. Readers of “East Winds” will find regular reporting and insights from Michael on major developments in China’s energy policy and markets. Stay tuned!]

Lack of legislative authority

On Shenzhen’s big day, experts from several of the carbon trading pilots gathered in Beijing for the Tsinghua-MIT China Energy and Climate Project annual meeting to share the challenges on the ground. Since the pilots were announced in 2011, local governments have lamented the fact that despite the mandate to establish a CO2 cap, they have no legal basis to impose fines on noncompliant entities. Such authority can only come from central government legislation, thus far lacking. Shenzhen, whose guidelines at least indicate fines of three times the market price [link in Chinese], may feel it has special leeway to impose penalties because of its special administrative status bestowing greater economic autonomy. Other municipalities are getting creative: Tianjin is reportedly threatening to withhold preferential loan rates from non-compliant emitters.

Most allowances in the pilots are being given away freely, based on some or all of these allocation principles: 1) Grandfathering – permit allocations are based on historic emissions (e.g., 2009-2011); 2) Benchmarking – permits are allocated based on expected declines in carbon intensity by sector; and 3) Equity – permits are allocated taking into account the level of economic development and existing energy conversation efforts. The first two are quantitative but suffer from data quality concerns; the third is more subjective but in line with current policy such as the 12th Five-Year Plan’s provincial carbon intensity targets. The governments are also holding on to some of the permits to create a reserve that can be released to regulate price spikes.

In principle, any allocation scheme of equal total permits should result in the same mitigation effort, but total welfare impacts may differ substantially based on the relative weighting of the above factors. In particular, as China eyes linking these systems together nationally, the imbalance of carbon-exporting and carbon-importing regions may lead to significant inequities between provinces – China’s domestic parallel to concerns surrounding embedded carbon in international trade. My colleagues have shown that a hybrid target-setting approach weighted by both production and consumption provides an equitable and efficient burden allocation, which could inform provincial cap setting in a national ETS.

Covered entities and industries vary by region

The seven pilots were chosen based on differing levels of economic development and industrial structure, leading to some variation in the sectors covered by the carbon markets and the emission thresholds set for each province. Chongqing is the only pilot to not include the power sector. At the lower end in terms of total percentage, Chongqing and Hubei are both among China’s poorer regions, with per capita GDP less than half of Beijing and Shanghai. Hubei’s carbon market, for example, only includes entities with annual energy use greater than 60,000 tons of coal-equivalent (153 large enterprises province-wide), while Beijing set its threshold at 10,000 tons of CO2 and includes indirect emissions (i.e., upstream emissions associated with the electricity they consume), bringing medium-sized factories, institutions and some commercial buildings into the fold.

Stricter caps in China’s industrialized eastern provinces may accelerate the movement of energy-intensive industries to the less-developed west (referred to as “leakage”), where electricity prices are kept low to encourage economic development. Worries of uncompetitive industries may pit eastern provincial officials with angry mayors losing factories against western officials welcoming them with open arms, leading to more political delays.

In contrast to other ETS examples, China’s power sector may ultimately be the most difficult to cover by an emissions trading system (ETS). The electricity tariffs or rates charged to retail customers are strictly regulated to counter inflation and promote development, preventing the usual pass-thru of carbon costs to consumers. In the case of Beijing, which has sworn off building new coal plants, allocations to existing plants will be based on expected efficiency improvements and new plants on natural gas. Imported electricity carbon content will be allocated directly to large energy consumers based on the North China Grid average. Allocating permits becomes more complicated in provinces heavily dependent on coal within their own borders.

In the post-2020 climate regime, China has written off taking the lion’s share of Clean Development Mechanism (CDM) credits – carbon reductions exchangeable at EU ETS prices that China has enjoyed through the UN’s climate change framework. An eventual national ETS would provide a huge potential market for these projects. Given the difficulties encountered even with the relatively limited scope of these seven pilots, few are optimistic that a national system will be ready by 2016 as originally planned. 2020 is more reasonable. However, it will face even greater hurdles linking with developed country ETS markets, despite their eagerness to scoop up emissions reductions at rock-bottom prices.

A well-functioning carbon trading system relies on good accounting – measuring, reporting and verification (MRV) of achieved reductions – otherwise less-effective projects might flood the market and erode climate gains. China’s domestic MRV system, which became a serious point of contention at the Copenhagen international climate negotiations, is causing headaches for the domestic trading pilots as well. Provinces are notoriously over-reliant on industry for data, even as turf battles continue within government over data sharing (recommended reading: Pew-Tsinghua workshop slides on MRV). MRV guidelines and electronic emissions inventories are still being developed in many pilots.

When it comes to carbon offsets, it is the Wild West in China. Most pilots allow covered entities to use some amount of China Certified Emissions Reductions (CCER), which include [link in Chinese]: CDM CERs, international voluntary credits (e.g., VCS, Gold Standard) and Chinese voluntary credits. Chongqing and Hubei may allow forestry credits for select projects as well. China will face skeptical carbon trading partners in other international ETS markets with more transparent data collection procedures until it resolves these irregularities.

While all pilots are supposed to launch this year, expect some delays as local governments grapple with these fundamental ETS issues. But if history is any indication, China will learn rapidly from its successes and failures. By 2016, functioning trading platforms will have been created, some initial regional integration may be in the works, and the most difficult questions (e.g., power sector permit allocation) will be under intense discussion. Several barriers exist, but the prospect of replacing dwindling energy-intensive exports with carbon credit exports may just be a carrot big enough to bring all the pieces together.

Michael is a MS candidate and pre-doctoral student in engineering systems at the Massachusetts Institute of Technology. Prior to MIT, he was the US-China Climate Policy Coordinator at the Natural Resources Defense Council in Washington, DC, where he analyzed clean energy developments and helped coordinate advocacy strategies in both countries. In 2008-9, he was the recipient of a Fulbright ...